The average American still feeling the effects of the Great Recession can be forgiven for not being riveted on the fact that state and local governments across the country are facing another fiscal crisis in the form of a public pension “tsunami” of epic proportions. Fixing the problem will require fundamental changes to public retirement plans.
According to Standard & Poor’s, 32 states are confronting budget shortfalls in fiscal 2015 and/or 2016. One contributor to those ills is growing unfunded public pension liabilities that now range as high as $4.7 trillion nationwide according to a report from State Budget Solutions, a non-profit organization that advocates for state budget reform. The unfunded liability works out to about $15,000 per person.
Public employees have been promised more than state and local governments can ever afford to pay and taxpayers are on the hook for the shortfalls. Many retirement plans are not setting aside enough money to make good on their promises to current and retired state employees. Some, such as Detroit and Stockton, Calif., have already declared bankruptcy; countless public pension systems are in dire shape.
Moody’s dropped Chicago’s bond rating to junk status after the Illinois Supreme Court overturned state pension reforms. That means the Chicago taxpayers will be paying higher interest rates on the money the city borrows.
Last week the New Jersey Supreme Court ruled that the state did not have to increase its contribution to ensure the solvency of its ailing pension system. Politicians there found that shifting liabilities into the future by underfunding pensions was a convenient way to deliver on promises of low taxes and richer retirement benefits.
In Massachusetts, unfunded state and local pension and retiree health care liabilities total around $75 billion.
Most state and local governments in the United States offer defined-benefit pension plans to which both employees and employers contribute. The plans are supposed to provide public employees with guaranteed income, creating a financial liability for taxpayers when workers retire. Under this type of plan employees accrue the right to an annual benefit usually determined as a percentage of a worker’s average salary over the final years of employment multiplied by the worker’s years of service.
Under this arrangement, the employer is responsible for determining how much to set aside for employees’ retirement fund and how to invest it. Government (taxpayers) assumes the risk of coming up with the extra money if there is a shortfall. Government has several basic options in that case: they can raise taxes, make budget cuts, or default on their obligations. Given the magnitude of pension liabilities, some states may seek a federal bailout as was done for Wall Street and the automakers.
In contrast, the defined contribution plans that now prevail in the private and not-for-profit sectors empower employees to save for their own retirement and manage their own investments. A defined contribution plan transfers investment risk from the employer to the employee.
These are the simplest, most transparent, portable and straightforward pension plans. The employee and employer both contribute, the employee decides where to invest the funds and bears responsibility for investment risk. Upon retirement, there is often an opportunity to cash out with a lump sum payment or to select an annuity whereby payments are made to the retiree over a specified period.
However bad the problems are now, the pension situation is likely to get worse as politicians continue to “kick the can down the road,” the cliche that describes politicians’ response to virtually every fiscal crisis. One thing that would help would be to replace current defined benefit plans with a defined contribution plan for new public employees as Georgia, Michigan, Utah, and Oklahoma have done.
Such a move would minimize the risk of one major but often forgotten stakeholder: taxpayer.
originally published: June 20, 2015